September 15, 2004

Choosing the Strike Price
by John Brasher, CallWriter Publisher

One of the decisions that the covered call writer must make before putting a trade on is which strike call to write. There frequently will be two or three calls offering attractive returns. The decision of which strike to write depends on a number of factors, which we discuss today. The choice of strike price is up to the trader and will depend on the evaluation of two factors:

1.  Where the trader thinks the stock price is going.

    and

2.  How much downside protection is desired.

These two questions are highly inter-related, because the amount of premium received directly affects the downside risk and is important if the stock drops or begins showing technical weakness. Consistently writing in-the-money calls and getting a small return when stocks are performing well is to leave money on the table. On the other hand, writing out-of-the-money calls when the market is declining is a poor strategy, since not enough downside protection is being received.

Let's examine the various effects of writing some hypothetical calls with different strikes on XYZ Corp. (XYZ). Let's assume that the stock is in a very gentle uptrend, not showing technical weakness but not a lot of strength, either, and that it meets our requirements for writing covered calls. Let's compare the effects of writing the 22.50, 20 and 17.50 XYZ Calls:

Stock Price = $19.75	Strike	Premium	Return If Called	Breakeven Point
Out of the Money (OTM)	$22.50	$0.80	18%	$18.95
At the Money (ATM)	$20	$1.20	7.5%	$18.55
In the Money (ITM)	$17.50	$2.95	3.7%	$16.80

Reviewing the returns from the different strikes, we like the 20 Call best. Here's why:

(1)	The stock is showing enough strength that we felt no need to take a smaller return on the ITM call for more downside protection.
(2)	We are unpersuaded that the OTM 22.50 call makes sense, either, since the chances of a price advance to or above the $22.50 level by expiration don't seem good. Thus there is no point taking a much smaller premium for the OTM 22.50 call.
(3)	Since it is only slightly out of the money, the 20 Call it is almost an ATM call, but being slightly out of the money is even better, since there is an extra payoff if the stock is called out.

Here are some good general guidelines:  If the underlying stock is downtrending, write ITM, since they offer the greatest downside protection and are the most likely to be called out. If in a range or gentle uptrend, ATM calls work best since they generally offer the highest returns, offer good downside protection and are very likely to be called out. OTM calls should only be used on stocks in a moderate to strong uptrend, because the sky-high returns the promise only are realized if the stock moves enough that they are called out, and they offer only decent returns and very little downside protection if not called out.

CallWriter views the selection of the strike price as an inextricable part of the trading decision. In covered call trading, the selection of the strike price is an important choice that affects returns and that even determines whether the trade is a go or no-go in the first place. If you think the stock likely to turn down or turn up before expiration, that technical evaluation is suggesting to you which strike to write, assuming the trade makes sense to begin with. In fact, a stock might be writable as a deeply ITM play but not otherwise, which indicates how integral the analysis of the different call strikes is to the trade decision itself.

Example:  Writing OTM calls on stocks that are not likely to be called (and aren't called out) minimizes returns and exposes the trader to greater risk due to the lack of downside protection obtained.

TIP:  Only one strike for a particular stock may appear on our Real Time Lists™ at any time. But there is a way to look at other strikes for that stock. Simply click on the Option Symbol on the list, which pulls up a CallWriter Research Page with covered call chains that provide pre-calculated returns (not simple option chains). Review a couple of other strikes to see if their returns are of interest. If you are not satisfied with a particular strike call despite the return offered, and cannot find another strike that meets your requirements for return and downside protection, pass on the trade.

Good luck and good trading!